Climate Change Exposure and Bankruptcy Risk

Abstract This research documents that a firm's bankruptcy risk increases with its climate change exposure. This study further investigates the underlying mechanisms and finds that this effect is stronger for firms with lower operating cash flows or tighter financial constraints. Consistent with the agency theory of debt, the evidence suggests that improving the protection of creditor rights can mitigate the adverse impact of climate change. In addition, two distinct sets of quasi‐natural experiments are exploited to establish causality and eliminate alternative explanations. Specifically, the positive effect of climate change exposure on bankruptcy risk is weaker after the 2015 Paris Agreement, which raised public awareness of climate issues, and stronger for firms headquartered in countries that are more severely affected by natural disasters. Cross‐sectional analyses reveal that the main effect is more pronounced among loss firms, firms with higher levels of asset tangibility, cash flow volatility or profit volatility, and firms with worse solvency performance. Overall, the collective evidence indicates that climate change has real consequences for firm financial conditions.